Liquidity, Trends and the Great Recession

Abstract

We study the impact that the liquidity crunch in 2008-2009 had on the U.S. economy’s growth trend. To this end, we propose a model featuring endogenous growth a la Romer and a liquidity friction a la Kiyotaki-Moore. A key finding in our study is that liquidity declined around the demise of Lehman Brothers, which lead to the severe contraction in the economy. This liquidity shock was a tail event. Improving conditions in financial markets were crucial in the subsequent recovery. Had conditions remained at their worst level in 2008, output would have been 20 percent below its actual level in 2011.